From Commercial to Residential: Exchanging Out of a Vacant or Aging Commercial Building

A vacant building still qualifies, because the test is why you hold it, not whether it has tenants

Reg. section 1.1031(a)-1(b) says unproductive real estate held by a non-dealer for future use or for an increase in value is held for investment. An empty office building you are holding for re-leasing or resale to an investor meets that test even with no rent coming in.

What does not qualify is property held primarily for sale under section 1031(a)(2). If you convert the building into condominiums and sell units, the units are inventory, and so is the building once the conversion is the plan. The office building page and retail strip center page cover selling each type.

Check that you have a gain first: an exchange defers losses just as it defers gains

Section 1031 is mandatory when its conditions are met, so it defers a loss along with a gain. If your adjusted basis is above what the building will sell for, a taxable sale lets you use the loss and an exchange does not; see 1031 when selling at a loss.

A building that has sat empty may also have suspended passive losses. Publication 925 releases them only when you dispose of your entire interest in the activity in a fully taxable transaction to an unrelated person, so an exchange keeps them suspended. Ask your CPA for the Form 8582 carryover before choosing; suspended passive losses and a 1031 covers the trade-off.

Depreciation speeds up only on new basis: carried-over basis keeps the commercial schedule

Section 168(c) gives nonresidential real property 39 years and residential rental property 27.5 years, and a building is residential rental only if 80% or more of its gross rent comes from dwelling units.

For the basis you carry over, Reg. section 1.168(i)-6(c)(4)(ii) says that when the replacement has a shorter recovery period, the exchanged basis keeps the relinquished property's recovery period and is depreciated over what remains of it. Basis added with new debt or cash is depreciated over 27.5 years. Paragraph (i) lets you elect out and treat the whole basis as newly placed in service.

Hypothetical: $1,000,000 of new building basis over 27.5 years yields about $36,364 a year, against $25,641 over 39 years. Run your own numbers with your CPA.

Worked model: a $2,000,000 empty office building into a multifamily mix

Hypothetical round numbers for illustration only. Your own figures and your lender's terms will differ.

• The building cost $1,500,000 years ago, and $500,000 of depreciation brings adjusted basis to $1,000,000. It sells for $2,000,000 with $100,000 of costs, so the amount realized is $1,900,000 and the gain is $900,000, of which $500,000 is depreciation taxed at up to 25% on a cash sale.
• The $1,000,000 loan is paid off at closing, leaving $900,000 with the qualified intermediary.
• To defer the whole gain the owner acquires at least $1,900,000 of replacement property with at least $1,000,000 of debt or added cash, for example $900,000 of exchange cash into a $1,900,000 apartment building with a $1,000,000 loan, or a mix of a smaller building and multifamily DST interests whose allocated loans count toward the debt.
• Replacement basis is $1,000,000, the old adjusted basis, plus nothing added, because the new debt replaces the old debt dollar for dollar.
• Because no basis was added, the apartments' depreciation follows the office building's remaining 39-year schedule under Reg. section 1.168(i)-6 unless the owner elects out. The faster 27.5-year life helps only to the extent the owner adds cash or debt beyond what was paid off.

Residential property brings tenant law that a commercial owner never had to manage

Commercial leases are largely governed by the contract. Residential tenancies are governed by state statute as well, and several states cap annual rent increases on older buildings. California's Civil Code section 1947.12 limits increases to 5% plus the change in the cost of living, or 10%, whichever is lower, for most housing more than 15 years old.

Oregon's ORS 90.323 caps increases at the percentage the state calculates each year, which the Office of Economic Analysis set at 9.5% for 2026 and 10% for 2027, with units under 15 years old exempt. Washington's RCW 59.18.700 limits increases to 7% plus inflation, or 10%, whichever is less. None of these rules applies to the commercial leases you are leaving.

If you will manage apartments yourself, learn the eviction notice rules and any local rent rules before day 45. Exchanging into a landlord-friendly state compares the main differences between states.

Multifamily DSTs let you move into residential without becoming a residential landlord

A DST interest in an apartment community is real property for exchange purposes under Rev. Rul. 2004-86. The sponsor handles leasing and the tenant law, and decides when to sell. Distributions are not guaranteed, interests are illiquid, and the trust cannot raise new capital for major repairs.

Our traditional DST offerings include multifamily properties, typically at $100,000 to $250,000 per offering, so one commercial sale can spread across several. Under Reg. section 1.1031(k)-1(c)(4) you may identify three properties of any value or any number up to 200% of the building's value, which leaves room for a direct apartment purchase with DST interests named as backups. If you want to go the other way later, residential to commercial covers that move, and the apartment building page covers buying one directly.